Tax Analysts Blog

Is the U.S. Tax Gap as Big as Italy’s?

Posted on Mar 4, 2013

The United States has a tax gap problem. The IRS has estimated that the tax gap may be as much as $450 billion a year. That’s approximately 18 percent of total federal revenues. As Senate Finance Committee Chair Max Baucus pointed out during the healthcare debate, closing the tax gap could have paid for Obamacare and more. As much as 15 percent of U.S. GDP may be in an untaxed, underground economy (approximately $2 trillion). Despite the tax gap, for the most part the IRS and Congress trumpet the success of the voluntary compliance system, with Republicans frequently doing their best to limit increased enforcement (particularly of individuals). But numbers from a New York Times article about Italian tax evasion suggest that the United States isn’t doing much better than one of Europe’s most notoriously inefficient tax collectors.

A January New York Times story on Italy’s quest to crack down on tax cheats pointed out that up to 18 percent of the Italian economy may be underground. If the Italian government could collect taxes on that portion of national income, it would raise as much as $162 billion. Italy’s total tax revenues in 2010 were about $550 billion (€403 billion). That means that Italy’s tax gap is about 29.5 percent of its total revenues. Although that sounds significantly worse than our tax gap, it’s probably misleading. The U.S. federal government only taxes about 18.5 percent of GDP (total taxes at all levels come to about 24 percent, according to the OECD). Italian taxes at all levels average around 42 percent of GDP. So one possible reason that the Italian tax gap looks worse is that Italians are evading much higher rates. If the United States taxed 40 percent of GDP, the $2 trillion going untaxed would cost all levels of government $800 billion!

If the numbers in the Times story are to believed, the United States and Italy have underground economies of a proportionally similar size. Could that be true? It depends on whose numbers you believe. The Times cites Italian statistics on the size of the underground economy, which is where the 18 percent figure comes from. But as recently as 2011, former Italian Prime Minister Silvio Berlusconi put the number at 25 percent. The IMF estimates it at 27 percent, while the European Commission puts it at nearly 22 percent. That number is key because the larger the shadow economy, the lower the rate of tax compliance.

In its report on the tax gap, the IRS estimates U.S. tax compliance at 83 percent, but other sources have the U.S. shadow economy as small as 10 percent of GDP. While there might not be a big difference between 15 percent and 18 percent, there is a major distinction between 10 percent and 25 percent. In fact, that’s probably the difference between a tax gap crisis and having a reasonably functional voluntary compliance system.

In fairness to the Times, its story was primarily about the redditometro, a new audit technique in Italy that measures personal expenditures to locate taxpayers who are misrepresenting their income. The discussion of the underground Italian economy (and the numbers) is presented almost in passing. But the point of the story was that Italy’s shadow economy is so huge that it requires invasive examinations of all categories of taxpayer spending. (If their spending was more than 20 percent over their reported income, Italians will be expected to provide the revenue agency with an explanation.) That point is weakened if the shadow economy is underestimated by 40 percent. And if you think that the U.S. shadow economy is almost the same percentage of GDP as the Italian, then the implication is that the United States needs a redditometro of its own. It would be 1998 all over again.

Congress used to focus on the tax gap as a means of raising revenue, but it has abandoned that approach in recent years. Violent objections to increased reporting requirements have led lawmakers to back off in their quest to tax the underground economy. And that’s probably not a catastrophic decision. All tax systems will produce some amount of leakage and, despite what the numbers in the Times story imply, the United States isn’t doing quite as badly as Italy or other European states with decrepit tax systems.

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